Economics Working Paper Archive at WUSTL

North outlines five propositions about institutional change and explains its meanings.
He lays out a specific agenda for the study of institutions that is different from
game theoretic or spatial political modeling of institutions. The focus is a transaction
cost approach to institutions and a cognitive science approach to "rational" choice.
While the former--the transaction cost approach--is at least partly complementary
to game theoretic approaches, the latter suggests a distinct departure from much
of the current rational choice theory.

A theory of institutional change is essential for further progress in the social
sciences in general and economics in particular, because neo-classical theory (and
other theories in the social scientist's tool bag) at present cannot satisfactorily
account for the very diverse performance of societies and economies both at a moment
of time and over time. North sketches out a framework for analyzing institutions.
This framework builds on the economic theory of choice subject to constraints. However
it incorporates new assumptions about both the constraints that individuals face
and the process by which they make choices within those constraints. Among the traditional
neoclassical assumptions that are relaxed are those of costless exchange, perfect
information, and unlimited cognitive capabilities. Too many gaps still remain in
our understanding of this new approach to call it a theory. North presents a set
of definitions, principles, and a structure, which provide much of the scaffolding
necessary to develop a theory of institutional change.

The performance of an economy is a function of both the institutions and technology
developed in a society but the literature on productivity is devoid of any discussion
of the institutional foundations of the economy. Instead that literature and the
growth accounting quantitative foundations of that analysis focus on the significance
of the capital stock, technology, R&D, and savings in the rate of growth of productivity.
The new growth economics literature equally equates growth with human capital investment,
physical capital, savings and sometimes as a negative function of population growth.
The argument of this essay is that productivity increases result from both improvements
in human organization and from technological developments.

We examine the effects of market structure and the internal organization of firms
on equilibrium R&D projects. We compare a monopolist’s choice of R&D portfolio
to that of a welfare maximizer. We next show that Sah and Stiglitz’s finding
that the market portfolio of R&D is independent of the number of firms under Bertrand
competition extends to neither Cournot oligopoly nor a cartel. We also show that
the ability of firms to pre-empt R&D by rivals along particular research paths can
lead to socially excessive R&D diversification. Lastly, using Sah and Stiglitz’s
definition of hierarchy, we establish conditions under which larger hierarchies invest
in smaller portfolios.

Denzau and North argue that ideas matter, and that the way that ideas are communicated
among people is crucial to building useful theories that will enable us to deal with
strong uncertainty problems at the individual level. Under conditions of uncertainty,
individuals' interpretation of their environment will reflect the learning that they
have undergone. Individuals with common cultural backgrounds and experiences will
share reasonably convergent mental models, ideologies and institutions and individuals
with different learning experiences (both cultural and environmental) will have different
theories (models, ideologies) to interpret that environment. It is the argument of
this essay that in order to understand decision making under such conditions of uncertainty
we must understand the relationship between the mental models that individuals construct
to make sense out of the world around them, the ideologies that evolve from such
constructions, and the institutions that develop in a society to order interpersonal
relationships.

This essay elaborates, extends and modifies a "Neo-Classical Theory of the State"
(North, 1981, Ch. 3) in three directions: 1. it incorporates time into the model;
2. it is explicitly concerned with the perceptions- -the belief systems--that determine
choices; and 3. it relates the belief systems to the external environment of the
players; both the past environmental experiences that are incorporated in cultural
conditioning and the present environmental experiences incorporated in "local learning".

An economic definition of transaction costs is the costs of measuring what is being
exchanged and enforcing agreements. In the larger context of societal evolution they
are all the costs involved in human interaction over time. It is this larger context
that North explores in this essay. The concept is a close kin to the notion of social
capital advanced by James Coleman (1990) and applied imaginatively to studying the
differential patterns of Italian regional development by Robert Putnam in Making
Democracy Work (1993). This essay, therefore, is a study in economic history which
focuses on the costs of human coordination and cooperation through time which I regard
as the key dilemma of societies past, present and future.

This paper explores the relationship between the structure of the market for the reÞning and distribution of gasoline and the wholesale price of unbranded gasoline sold to independent gasoline retailers. Theoretically, the eect of an increase in vertical integration is ambiguous because opposing forces act to increase and decrease wholesale prices. We empirically examine the eects of vertical and horizontal market structures on wholesale prices using both a broad panel and an event analysis. The panel covers twenty-six metropolitan areas from January 1993 through June 1997. The event is a merger of Tosco and Unocal in 1997 that changed the vertical and horizontal structure of thirteen West Coast metropolitan areas. Both data sets show that an increase in the degree of vertical integration is associated with higher wholesale prices.

Improving our understanding of the nature of economic change entails that we draw
on the only laboratory that we have--the past. But "understanding" the past entails
imposing order on the myriad facts that have survived to explain what has happened--that
is theory. The theories we develop to understand where we have been come from the
social sciences. Therefore there is a constant give and take between the theories
we develop, and their application to explain the past. To begin we need to assess
what we have learned from the past and then assess the usefulness of the tools at
hand--i.e. the rationality assumption and growth theory we employ in economics? We
will then go on to explore in subsequent sections some recent development that offer
the promise of improving our understanding of the past and of where we are going.